In the microcap world, channeling Ben Graham is normally a difficult proposition. When small- and micro-cap stocks trade at lower than their price to book value, its usually for one reason: lack of staying power. So its not often that you see recognizable brands trade below book value, much less brands that have best-in-class products. When companies with solid products trade at such a discount, it usually means an opportunity. At current levels, the opportunity in Rosetta Stone (RST) is difficult to ignore.
Rosetta Stone's share price has been battered over the past year with shares down 67% as revenue growth has come to a screeching halt. The US military and other government agencies have cut back purchases of the premium-priced product as spending gets reigned in, and consumers also look less likely to break out their checkbooks to pay for a language software that costs five times more than most rival software. This has clouded the outlook for Rosetta Stone's shares, causing the company to be revalued from former growth king to struggling brand.
Those are the negatives. But when we look at the valuation, its hard not to believe the worst is already priced in. The company sports $111 million in cash on the books, another $60 million in accounts receivable, and no debt. From a balance sheet perspective, Rosetta Stone can continue to operate at current levels for years without calling into question its ability to fund itself. But how does Rosetta Stone turn itself around?
To be sure, part of the story is that a broader economic slowdown has hurt demand for a premium-priced product, and that an economic rebound would provide a much needed boost for product sales. But buying Rosetta Stone on the basis of an economic recovery is a bridge too far for me. Instead, I find the story compelling I believe Rosetta Stone can carve out efficiencies that would return the company to profitability even in the current economic environment.
Looking at the financials, the answer seems pretty clear. Since 2008, revenue at Rosetta Stone is up 19%. SG&A, meanwhile, has exploded, up 38%. As the company has expanded its brand it has clearly run up against diminishing marginal returns in its sales force. Language software that costs $500 is always going to be a niche product, and Rosetta Stone's sales army is simply too expensive. The scope for cutbacks in the US appears substantial, even as the company continues investing in and growing its brand overseas.
Having used the product, as well as several other language softwares, there is no question that Rosetta Stone has best-in-class technology and that nobody has yet replicated the Rosetta Stone experience at a lower price point. It is a strong brand, and for those willing to spend big money on language software, the product sells itself pretty well. The strategy of trying to force sales by beefing up the sales team has been ineffective and unprofitable, and my belief is that Rosetta Stone can return to a smaller and more efficient sales force without much damage to revenue.
The scope for streamlining the business is significant, and along with international expansion, it provides upside for Rosetta Stone shares for years to come. Meanwhile, the downside appears limited as the company currently trades below book value, has more than $5 per share of cash, and no debt. That kind of risk/reward is rarely found among solid small-cap brands, and any small victory is likely to send Rosetta Stone shares sharply higher.
Disclosure: I am long RST.